Small-Cap Stocks Regaining Favor in Rough Market

The extreme volatility of the past seven weeks has sent investors looking for shelter from the storm. Small-cap stocks may provide a place to hide.

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Companies that populate the benchmark Russell 2000 index have gotten crushed in the landslide, losing as a group more than 17 percent since the market began to tumble July 7, while the Standard & Poor's 500 has dropped about 12 percent in the same period.

With an unpredictable period ahead, some investors think the parts of the market that sustained the heaviest damage will be best poised for gains.

"We can easily see how bargain-hunting by small/mid-cap investors can help fuel a short-term rally in small caps, at least as long as expectations for a recession and (exchange traded fund)-driven risk-off trades by hedge funds remain at bay," Lori Calvasina, small-cap analyst for Credit Suisse, wrote in an analysis for clients. "Our confidence that small caps will post gains in 2011 has admittedly improved."

Calvasina made her comments as part of a survey the firm conducted of its small-cap clients. For the most part, the results showed optimism about the climate ahead.

Some 31 percent surveyed believe the Russell 2000 has found its bottom, or is within 5 percent or less. Another 43 percent said there is another downside of 5 percent to 10 percent, while 14 percent predicted a downturn of 10 percent to 20 percent, and 4 percent saw a tumble of more than 20 percent ahead.

To be sure, such surveys can be contrarian tools—an overloading of investor sentiment is often a good indication that the market is ready to turn in the opposite direction.

Calvasina advised that investors buying small caps will be wading into an area "that has priced in a growth scare, not a recession" and that choices should be made carefully. Indeed, just 23 percent of respondents said there is a greater than 50 percent chance of recession.

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"We do think economic data points and company commentary about (third-quarter) business activity need to be monitored closely in the months ahead, as it does not appear to us that a double dip was priced into small-cap stock prices in recent weeks," she said.

Survey respondents were most favorable toward tech stocks and industrials, and least drawn to financials and materials. Credit Suisse has upgraded tech to "overweight" and cut utilities to "market weight."

The moves are consistent with investor mentality that looks for bargains when the market takes a beating.

"The Russell 2000 came down pretty hard. That means that there's some value created there," said Rob Lutts, chief investment officer at Cabot Money Management in Salem, Mass. "The lack of liquidity in that space has created some opportunities. You get a chance for some of these lower-volume names to offer opportunity."

Among the specific names Cabot has picked up is Volcano , a health-care company that makes catheters. The company's stock had been moving in a nearly parabolic fashion over the past two years before the recent downturn hit.

Individual investors, though, are better off using exchange-traded funds as a way to brace against volatility, Lutts said.

He recommends the Wisdom Tree Emerging Market Small Cap Dividend Fund that he says benefits investors in two ways—on gains in small-caps, as well as expected growth in developing countries.

"Emerging markets have underperformed, small caps have underperformed, so you can get an extra level of safety," he said.

That type of recovery off a strongly beaten down sector is what is fueling small-cap enthusiasm.

"If you're going to have a bounceback you'll get a lot of beta with small caps," said Philip Silverman, portfolio manager at Kingsview Management in New York. "You get a lot of action with them."